# The Relationship Between Inflation and Unemployment

```The Relationship Between Inflation and
Unemployment
The Phillips Curve
The Phillips curve shows the inverse relationship between inflation
and unemployment: as unemployment decreases, inflation increases.
LEARNING OBJECTIVES
Review the historical evidence regarding the theory of the Phillips curve
KEY TAKEAWAYS
Key Points

The relationship between inflation rates and unemployment rates
is inverse. Graphically, this means the short-run Phillips curve is
L-shaped.

A.W. Phillips published his observations about the inverse
correlation between wage changes and unemployment in Great
Britain in 1958. This relationship was found to hold true for other
industrial countries, as well.

From 1861 until the late 1960’s, the Phillips curve predicted rates
of inflation and rates of unemployment. However, from the 1970’s
and 1980’s onward, rates of inflation and unemployment differed
from the Phillips curve’s prediction. The relationship between the
two variables became unstable.
Key Terms


Phillips curve: A graph that shows the inverse relationship
between the rate of unemployment and the rate of inflation in an
economy.
stagflation: Inflation accompanied by stagnant growth,
unemployment, or recession.
The Phillips curve relates the rate of inflation with the rate of
unemployment. The Phillips curve argues that unemployment and
inflation are inversely related: as levels of unemployment decrease,
inflation increases. The relationship, however, is not linear.
Graphically, the short-run Phillips curve traces an L-shape when the
unemployment rate is on the x-axis and the inflation rate is on the yaxis.
Theoretical Phillips Curve: The Phillips curve shows the inverse trade-off between
inflation and unemployment. As one increases, the other must decrease. In this image,
an economy can either experience 3% unemployment at the cost of 6% of inflation, or
increase unemployment to 5% to bring down the inflation levels to 2%.
History
The early idea for the Phillips curve was proposed in 1958 by
economist A.W. Phillips. In his original paper, Phillips tracked wage
changes and unemployment changes in Great Britain from 1861 to
1957, and found that there was a stable, inverse relationship between
wages and unemployment. This correlation between wage changes
and unemployment seemed to hold for Great Britain and for other
industrial countries. In 1960, economists Paul Samuelson and Robert
Solow expanded this work to reflect the relationship between inflation
and unemployment. Because wages are the largest components of
prices, inflation (rather than wage changes) could be inversely linked
to unemployment.
The theory of the Phillips curve seemed stable and predictable. Data
from the 1960’s modeled the trade-off between unemployment and
inflation fairly well. The Phillips curve offered potential economic policy
outcomes: fiscal and monetary policy could be used to achieve full
employment at the cost of higher price levels, or to lower inflation at
the cost of lowered employment. However, when governments
attempted to use the Phillips curve to control unemployment and
inflation, the relationship fell apart. Data from the 1970’s and onward
did not follow the trend of the classic Phillips curve. For many years,
both the rate of inflation and the rate of unemployment were higher
than the Phillips curve would have predicted, a phenomenon known
as “stagflation. ” Ultimately, the Phillips curve was proved to be
unstable, and therefore, not usable for policy purposes.
US Phillips Curve (2000 – 2013): The data points in this graph span every month from
January 2000 until April 2013. They do not form the classic L-shape the short-run Phillips
curve would predict. Although it was shown to be stable from the 1860’s until the 1960’s,
the Phillips curve relationship became unstable – and unusable for policy-making – in the
1970’s.
Changes in aggregate demand cause movements along the Phillips
curve, all other variables held constant.
LEARNING OBJECTIVES
Relate aggregate demand to the Phillips curve
KEY TAKEAWAYS
Key Points

Aggregate demand and the Phillips curve share similar
components. The rate of unemployment and rate of inflation
found in the Phillips curve correspond to the real GDP and price
level of aggregate demand.

Changes in aggregate demand translate as movements along the
Phillips curve.

If there is an increase in aggregate demand, such as what is
experienced during demand-pull inflation, there will be an upward
movement along the Phillips curve. As aggregate demand
increases, real GDP and price level increase, which lowers the
unemployment rate and increases inflation.
Key Terms


Phillips curve: A graph that shows the inverse relationship
between the rate of unemployment and the rate of inflation in an
economy.
aggregate demand: The the total demand for final goods and
services in the economy at a given time and price level.
The Phillips Curve Related to Aggregate Demand
The Phillips curve shows the inverse trade-off between rates of
inflation and rates of unemployment. If unemployment is high, inflation
will be low; if unemployment is low, inflation will be high.
The Phillips curve and aggregate demand share similar components.
The Phillips curve is the relationship between inflation, which affects
the price level aspect of aggregate demand, and unemployment,
which is dependent on the real output portion of aggregate demand.
Consequently, it is not far-fetched to say that the Phillips curve and
aggregate demand are actually closely related.
To see the connection more clearly, consider the example illustrated
by. Let’s assume that aggregate supply, AS, is stationary, and that
aggregate demand starts with the curve, AD1. There is an initial
equilibrium price level and real GDP output at point A. Now, imagine
there are increases in aggregate demand, causing the curve to shift
unemployment decreases as more workers are hired, real GDP output
increases, and the price level increases; this situation describes a
demand-pull inflation scenario.
Phillips Curve and Aggregate Demand: As aggregate demand increases from AD1 to
AD4, the price level and real GDP increases. This translates to corresponding movements
along the Phillips curve as inflation increases and unemployment decreases.
As more workers are hired, unemployment decreases. Moreover, the
price level increases, leading to increases in inflation. These two
factors are captured as equivalent movements along the Phillips curve
from points A to D. At the initial equilibrium point A in the aggregate
demand and supply graph, there is a corresponding inflation rate and
unemployment rate represented by point A in the Phillips curve graph.
For every new equilibrium point (points B, C, and D) in the aggregate
graph, there is a corresponding point in the Phillips curve. This
illustrates an important point: changes in aggregate demand cause
movements along the Phillips curve.
The Long-Run Phillips Curve
The long-run Phillips curve is a vertical line at the natural rate of
unemployment, so inflation and unemployment are unrelated in the
long run.
LEARNING OBJECTIVES
Examine the NAIRU and its relationship to the long term Phillips curve
KEY TAKEAWAYS
Key Points

The natural rate of unemployment is the hypothetical level of
unemployment the economy would experience if aggregate
production were in the long-run state.

The natural rate hypothesis, or the non-accelerating inflation rate
of unemployment (NAIRU) theory, predicts that inflation is stable
only when unemployment is equal to the natural rate of
unemployment. If unemployment is below (above) its natural rate,
inflation will accelerate (decelerate).

Expansionary efforts to decrease unemployment below the
natural rate of unemployment will result in inflation. This changes
the inflation expectations of workers, who will adjust their nominal
wages to meet these expectations in the future. This leads to
shifts in the short-run Phillips curve.

The natural rate hypothesis was used to give reasons for
stagflation, a phenomenon that the classic Phillips curve could not
explain.
Key Terms


Natural Rate of Unemployment: The hypothetical
unemployment rate consistent with aggregate production being at
the long-run level.
non-accelerating inflation rate of unemployment: (NAIRU);
theory that describes how the short-run Phillips curve shifts in the
long run as expectations change.
The Phillips curve shows the trade-off between inflation and
unemployment, but how accurate is this relationship in the long run?
According to economists, there can be no trade-off between inflation
and unemployment in the long run. Decreases in unemployment can
lead to increases in inflation, but only in the short run. In the long run,
inflation and unemployment are unrelated. Graphically, this means the
Phillips curve is vertical at the natural rate of unemployment, or the
hypothetical unemployment rate if aggregate production is in the longrun level. Attempts to change unemployment rates only serve to move
the economy up and down this vertical line.
Natural Rate Hypothesis
The natural rate of unemployment theory, also known as the nonaccelerating inflation rate of unemployment (NAIRU) theory, was
developed by economists Milton Friedman and Edmund Phelps.
According to NAIRU theory, expansionary economic policies will
create only temporary decreases in unemployment as the economy
will adjust to the natural rate. Moreover, when unemployment is below
the natural rate, inflation will accelerate. When unemployment is
above the natural rate, inflation will decelerate. When the
unemployment rate is equal to the natural rate, inflation is stable, or
non-accelerating.
An Example
To get a better sense of the long-run Phillips curve, consider the
example shown in. Assume the economy starts at point A and has an
initial rate of unemployment and inflation rate. If the government
decides to pursue expansionary economic policies, inflation will
increase as aggregate demand shifts to the right. This is shown as a
movement along the short-run Phillips curve, to point B, which is an
unstable equilibrium. As aggregate demand increases, more workers
will be hired by firms in order to produce more output to meet rising
demand, and unemployment will decrease. However, due to the
higher inflation, workers’ expectations of future inflation changes,
which shifts the short-run Phillips curve to the right, from unstable
equilibrium point B to the stable equilibrium point C. At point C, the
rate of unemployment has increased back to its natural rate, but
inflation remains higher than its initial level.
NAIRU and Phillips Curve: Although the economy starts with an initially low level of
inflation at point A, attempts to decrease the unemployment rate are futile and only
increase inflation to point C. The unemployment rate cannot fall below the natural rate of
unemployment, or NAIRU, without increasing inflation in the long run.
The reason the short-run Phillips curve shifts is due to the changes in
inflation expectations. Workers, who are assumed to be completely
rational and informed, will recognize their nominal wages have not
kept pace with inflation increases (the movement from A to B), so their
real wages have been decreased. As such, in the future, they will
renegotiate their nominal wages to reflect the higher expected inflation
rate, in order to keep their real wages the same. As nominal wages
increase, production costs for the supplier increase, which diminishes
profits. As profits decline, suppliers will decrease output and employ
fewer workers (the movement from B to C). Consequently, an attempt
to decrease unemployment at the cost of higher inflation in the short
run led to higher inflation and no change in unemployment in the long
run.
The NAIRU theory was used to explain the stagflation phenomenon of
the 1970’s, when the classic Phillips curve could not. According to the
theory, the simultaneously high rates of unemployment and inflation
could be explained because workers changed their inflation
expectations, shifting the short-run Phillips curve, and increasing the
prevailing rate of inflation in the economy. At the same time,
unemployment rates were not affected, leading to high inflation and
high unemployment.
The Short-Run Phillips Curve
The short-run Phillips curve depicts the inverse trade-off between
inflation and unemployment.
LEARNING OBJECTIVES
Interpret the short-run Phillips curve
KEY TAKEAWAYS
Key Points

The long-run Phillips curve is a vertical line at the natural rate of
unemployment, but the short-run Phillips curve is roughly Lshaped.

The inverse relationship shown by the short-run Phillips curve
only exists in the short-run; there is no trade-off between inflation
and unemployment in the long run.

Economic events of the 1970’s disproved the idea of a
permanently stable trade-off between unemployment and
inflation.
Key Terms

Phillips curve: A graph that shows the inverse relationship
between the rate of unemployment and the rate of inflation in an
economy.
The Phillips curve depicts the relationship between inflation and
unemployment rates. The long-run Phillips curve is a vertical line that
illustrates that there is no permanent trade-off between inflation and
unemployment in the long run. However, the short-run Phillips curve is
roughly L-shaped to reflect the initial inverse relationship between the
two variables. As unemployment rates increase, inflation decreases;
as unemployment rates decrease, inflation increases.
Short-Run Phillips Curve: The short-run Phillips curve shows that in the short-term there
is a tradeoff between inflation and unemployment. Contrast it with the long-run Phillips
curve (in red), which shows that over the long term, unemployment rate stays more or
less steady regardless of inflation rate.
Consider the example shown in. When the unemployment rate is 2%,
the corresponding inflation rate is 10%. As unemployment decreases
to 1%, the inflation rate increases to 15%. On the other hand, when
unemployment increases to 6%, the inflation rate drops to 2%.
Historical application
During the 1960’s, the Phillips curve rose to prominence because it
seemed to accurately depict real-world macroeconomics. However,
the stagflation of the 1970’s shattered any illusions that the Phillips
curve was a stable and predictable policy tool. Nowadays, modern
economists reject the idea of a stable Phillips curve, but they agree
that there is a trade-off between inflation and unemployment in the
short-run. Given a stationary aggregate supply curve, increases in
aggregate demand create increases in real output. As output
increases, unemployment decreases. With more people employed in
the workforce, spending within the economy increases, and demandpull inflation occurs, raising price levels.
Therefore, the short-run Phillips curve illustrates a real, inverse
correlation between inflation and unemployment, but this relationship
can only exist in the short run. The idea of a stable trade-off between
inflation and unemployment in the long run has been disproved by
economic history.
Relationship Between Expectations and Inflation
There are two theories of expectations (adaptive or rational) that
predict how people will react to inflation.
LEARNING OBJECTIVES
Distinguish adaptive expectations from rational expectations
KEY TAKEAWAYS
Key Points

Nominal quantities are simply stated values. Real quantities are
nominal ones that have been adjusted for inflation.

Adaptive expectations theory says that people use past
information as the best predictor of future events. If inflation was
higher than normal in the past, people will expect it to be higher
than anticipated in the future.

Rational expectations theory says that people use all available
information, past and current, to predict future events. If inflation
was higher than normal in the past, people will take that into
consideration, along with current economic indicators, to
anticipate its future performance.

According to adaptive expectations, attempts to reduce
unemployment will result in temporary adjustments along the
short-run Phillips curve, but will revert to the natural rate of
unemployment. According to rational expectations, attempts to
reduce unemployment will only result in higher inflation.
Key Terms


adaptive expectations theory: A hypothesized process by which
people form their expectations about what will happen in the
future based on what has happened in the past.
rational expectations theory: A hypothesized process by which
people form their expectations about what will happen in the
future based on all relevant information.
The short-run Phillips curve is said to shift because of workers’ future
inflation expectations. Yet, how are those expectations formed? There
are two theories that explain how individuals predict future events.
Real versus Nominal Quantities
To fully appreciate theories of expectations, it is helpful to review the
difference between real and nominal concepts. Anything that is
nominal is a stated aspect. In contrast, anything that is real has been
adjusted for inflation. To make the distinction clearer, consider this
example. Suppose you are opening a savings account at a bank that
promises a 5% interest rate. This is the nominal, or stated, interest
rate. However, suppose inflation is at 3%. The real interest rate would
only be 2% (the nominal 5% minus 3% to adjust for inflation).
The difference between real and nominal extends beyond interest
rates. In an earlier atom, the difference between real GDP and
nominal GDP was discussed. The distinction also applies to wages,
income, and exchange rates, among other values.
The theory of adaptive expectations states that individuals will form
future expectations based on past events. For example, if inflation was
lower than expected in the past, individuals will change their
expectations and anticipate future inflation to be lower than expected.
To connect this to the Phillips curve, consider. Assume the economy
starts at point A at the natural rate of unemployment with an initial
inflation rate of 2%, which has been constant for the past few years.
Accordingly, because of the adaptive expectations theory, workers will
expect the 2% inflation rate to continue, so they will incorporate this
expected increase into future labor bargaining agreements. This way,
their nominal wages will keep up with inflation, and their real wages
will stay the same.
Expectations and the Phillips Curve: According to adaptive expectations theory,
policies designed to lower unemployment will move the economy from point A through
point B, a transition period when unemployment is temporarily lowered at the cost of
higher inflation. However, eventually, the economy will move back to the natural rate of
unemployment at point C, which produces a net effect of only increasing the inflation
rate.According to rational expectations theory, policies designed to lower unemployment
will move the economy directly from point A to point C. The transition at point B does not
exist as workers are able to anticipate increased inflation and adjust their wage demands
accordingly.
Now assume that the government wants to lower the unemployment
rate. To do so, it engages in expansionary economic activities and
increases aggregate demand. As aggregate demand increases,
inflation increases. Because of the higher inflation, the real wages
workers receive have decreased. For example, assume each worker
make \$102 in nominal wages, but \$100 in real wages. Now, if the
inflation level has risen to 6%. Workers will make \$102 in nominal
wages, but this is only \$96.23 in real wages.
Although the workers’ real purchasing power declines, employers are
now able to hire labor for a cheaper real cost. Consequently,
employers hire more workers to produce more output, lowering the
unemployment rate and increasing real GDP. On, the economy moves
from point A to point B.
However, workers eventually realize that inflation has grown faster
than expected, their nominal wages have not kept pace, and their real
wages have been diminished. They demand a 4% increase in wages
to increase their real purchasing power to previous levels, which
raises labor costs for employers. As labor costs increase, profits
decrease, and some workers are let go, increasing the unemployment
rate. Graphically, the economy moves from point B to point C.
This example highlights how the theory of adaptive expectations
predicts that there are no long-run trade-offs between unemployment
and inflation. In the short run, it is possible to lower unemployment at
the cost of higher inflation, but, eventually, worker expectations will
catch up, and the economy will correct itself to the natural rate of
unemployment with higher inflation.
Rational Expectations
The theory of rational expectations states that individuals will form
future expectations based on all available information, with the result
that future predictions will be very close to the market equilibrium. For
example, assume that inflation was lower than expected in the past.
Individuals will take this past information and current information, such
as the current inflation rate and current economic policies, to predict
future inflation rates.
As an example of how this applies to the Phillips curve, consider
again. Assume the economy starts at point A, with an initial inflation
rate of 2% and the natural rate of unemployment. However, under
rational expectations theory, workers are intelligent and fully aware of
past and present economic variables and change their expectations
accordingly. They will be able to anticipate increases in aggregate
demand and the accompanying increases in inflation. As such, they
will raise their nominal wage demands to match the forecasted
inflation, and they will not have an adjustment period when their real
wages are lower than their nominal wages. Graphically, they will move
seamlessly from point A to point C, without transitioning to point B.
In essence, rational expectations theory predicts that attempts to
change the unemployment rate will be automatically undermined by
rational workers. They can act rationally to protect their interests,
which cancels out the intended economic policy effects. Efforts to
lower unemployment only raise inflation.
Shifting the Phillips Curve with a Supply Shock
Aggregate supply shocks, such as increases in the costs of resources,
can cause the Phillips curve to shift.
LEARNING OBJECTIVES
Give examples of aggregate supply shock that shift the Phillips curve
KEY TAKEAWAYS
Key Points

In the 1970’s soaring oil prices increased resource costs for
suppliers, which decreased aggregate supply. The resulting costpush inflation situation led to high unemployment and high
inflation ( stagflation ), which shifted the Phillips curve upwards
and to the right.

Stagflation is a situation where economic growth is slow (reducing
employment levels) but inflation is high.

The Phillips curve was thought to represent a fixed and stable
trade-off between unemployment and inflation, but the supply
shocks of the 1970’s caused the Phillips curve to shift. This ruined
its reputation as a predictable relationship.
Key Terms


stagflation: Inflation accompanied by stagnant growth,
unemployment, or recession.
supply shock: An event that suddenly changes the price of a
commodity or service. It may be caused by a sudden increase or
decrease in the supply of a particular good.
The Phillips curve shows the relationship between inflation and
unemployment. In the short-run, inflation and unemployment are
inversely related; as one quantity increases, the other decreases. In
the long-run, there is no trade-off. In the 1960’s, economists believed
that the short-run Phillips curve was stable. By the 1970’s, economic
events dashed the idea of a predictable Phillips curve. What could
have happened in the 1970’s to ruin an entire theory? Stagflation
caused by a aggregate supply shock.
Stagflation and Aggregate Supply Shocks
Stagflation is a combination of the words “stagnant” and “inflation,”
which are the characteristics of an economy experiencing stagflation:
stagnating economic growth and high unemployment with
simultaneously high inflation. The stagflation of the 1970’s was caused
by a series of aggregate supply shocks. In this case, huge increases
in oil prices by the Organization of Petroleum Exporting Countries
(OPEC) created a severe negative supply shock. The increased oil
prices represented greatly increased resource prices for other goods,
which decreased aggregate supply and shifted the curve to the left. As
aggregate supply decreased, real GDP output decreased, which
increased unemployment, and price level increased; in other words,
the shift in aggregate supply created cost-push inflation.
Aggregate Supply Shock: In this example of a negative supply shock, aggregate supply
decreases and shifts to the left. The resulting decrease in output and increase in inflation
can cause the situation known as stagflation.
Shifting the Phillips Curve
The aggregate supply shocks caused by the rising price of oil created
simultaneously high unemployment and high inflation. At the time, the
dominant school of economic thought believed inflation and
unemployment to be mutually exclusive; it was not possible to have
high levels of both within an economy. Consequently, the Phillips
curve could not model this situation. For high levels of unemployment,
there were now corresponding levels of inflation that were higher than
the Phillips curve predicted; the Phillips curve had shifted upwards
and to the right. Thus, the Phillips curve no longer represented a
predictable trade-off between unemployment and inflation.
Disinflation
Disinflation is a decline in the rate of inflation, and can be caused by
declines in the money supply or recessions in the business cycle.
LEARNING OBJECTIVES
Identify situations with disinflation
KEY TAKEAWAYS
Key Points

Disinflation is not the same as deflation, when inflation drops
below zero.

During periods of disinflation, the general price level is still
increasing, but it is occurring slower than before.

The short-run and long-run Phillips curve may be used to illustrate
disinflation.
Key Terms



disinflation: A decrease in the inflation rate.
inflation: An increase in the general level of prices or in the cost
of living.
deflation: A decrease in the general price level, that is, in the
nominal cost of goods and services.
Inflation is the persistent rise in the general price level of goods and
services. Disinflation is a decline in the rate of inflation; it is a
slowdown in the rise in price level. As an example, assume inflation in
an economy grows from 2% to 6% in Year 1, for a growth rate of four
percentage points. In Year 2, inflation grows from 6% to 8%, which is
a growth rate of only two percentage points. The economy is
experiencing disinflation because inflation did not increase as quickly
in Year 2 as it did in Year 1, but the general price level is still rising.
Disinflation is not to be confused with deflation, which is a decrease in
the general price level.
Causes
Disinflation can be caused by decreases in the supply of money
available in an economy. It can also be caused by contractions in the
business cycle, otherwise known as recessions. The Phillips curve
can illustrate this last point more closely. Consider an economy initially
at point A on the long-run Phillips curve in. Suppose that during a
recession, the rate that aggregate demand increases relative to
increases in aggregate supply declines. This reduces price levels,
which diminishes supplier profits. As profits decline, employers lay off
employees, and unemployment rises, which moves the economy from
point A to point B on the graph. Eventually, though, firms and workers
adjust their inflation expectations, and firms experience profits once
again. As profits increase, employment also increases, returning the
unemployment rate to the natural rate as the economy moves from
point B to point C. The expected rate of inflation has also decreased
due to different inflation expectations, resulting in a shift of the shortrun Phillips curve.
Disinflation: Disinflation can be illustrated as movements along the short-run and longrun Phillips curves.
Inflation vs. Deflation vs. Disinflation
To illustrate the differences between inflation, deflation, and
disinflation, consider the following example. Assume the following
annual price levels as compared to the prices in year 1:

Year 1: 100% of Year 1 prices

Year 2: 104% of Year 1 prices

Year 3: 106% of Year 1 prices

Year 4: 107% of Year 1 prices

Year 5: 105% of Year 1 prices
As the economy moves through Year 1 to Year 4, there is a continued
growth in the price level. This is an example of inflation; the price level
is continually rising. However, between Year 2 and Year 4, the rise in
price levels slows down. Between Year 2 and Year 3, the price level
only increases by two percentage points, which is lower than the four
percentage point increase between Years 1 and 2. The trend
continues between Years 3 and 4, where there is only a one
percentage point increase. This is an example of disinflation; the
overall price level is rising, but it is doing so at a slower rate.
Between Years 4 and 5, the price level does not increase, but
decreases by two percentage points. This is an example of deflation;
the price rise of previous years has reversed itself.
Source: https://courses.lumenlearning.com/boundless-economics/chapter/the-relationship-betweeninflation-and-unemployment/
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